Wednesday, June 03, 2009

US Financial Conditions Are Best In Almost 1 Year

The Bloomberg U.S. Financial Conditions Index"combines yield spreads and indices from the Money Markets, Equity Markets, and Bond Markets into a normalized index. The values of this index are z-scores, which represent the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period."

MP: The chart above displays the Bloomberg U.S. Financial Conditions Index daily from May 1, 2008 through today (June 3, 2009), and shows that the index is approaching the same levels as June 2008. Based on this measure, financial conditions in the U.S. were at their worst and bottomed in October 2008, and have been improving steadily for the last 7 months. We're now getting back the same financial conditions that prevailed a year ago.

You mean the government guaranteeing everything under the sun and the Fed reducing the Fed Funds rate to zero and working the printing presses over-time to monetize every security from MBS to 30 year Treasuries will tighten credit spreads and make securities prices go higher?

Shocking.

If the Fed weren't in the midst of a massive pump and dump scheme, I'd believe these charts. This is just a con game to create charts like this to lure in the suckers.

Here are some exercises for some of your quantitatively minded students or colleagues:

(1) Is the Bloomberg index a statistically valid leading indicator of U.S. real GDP growth?(Hint: use Granger causality analysis.)

(2) If so, what would be a good specification for using past values of the index as a predictor for the next quarter's real GDP? (Hint: How about this quarter's real GDP growth rate depends on the last quarter's or the last two quarter's change in the Bloomberg index's average level. Or more simply, this quarter's change depends on the cumulative change in the past two quarters average level of financial conditions.)

(3) Using such a simple reduced form model of U.S. growth, what growth rate would you predict for the third quarter of 2009, assuming financial conditions remain near their current level until the end of this quarter?(Hint: you should get an answer much, much higher than the current Bloomberg consensus for 2009 Q3, which calls for growth at a seasonally adjusted annual rate of 0.5% -- try a number north of 8%.)

(4) Some final questions for discussion: Is the V-shaped recovery in financial conditions likely to be more consistent with a future economic forecast that looks more like an L, and U or a V? What appears to be the key direction of risk to consensus forecasts of tepid growth in the second half of 2009? What would surprising economic strength in the second half of 2009 mean for stock and bond markets? Why do you think professional forecasters have largely ignored the huge, measurable improvement in financial conditions even though the severity of the recession clearly seems to have been triggered by the massive deterioration in financial conditions following Lehman's bankruptcy?

All of the yield spreads are foolishly bullish. They are at the same level now as 2006. While default rates had already begun rising by then, those spreads reflected no awareness of risk whatsoever. Defaults are still rising yet still no sign of risk pricing in the spreads. The market is irrationally ignorant.

By the end of the year we will be over 10 percent unemployment and still rising. Obama will have another $1T deficit. We may have positive GDP growth by 4Q09 but all the gain will be from G. There will be no residential construction recovery until late 2010 or beyond.

Watch how the falling dollar destroys China's portfolio of T's slowing their lending to us and raising the price of oil.